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China Carbon Graphite's Growth Strategy For The Future

|Includes:Brookfield Asset Management Inc. (BAM), ZOLT

China Carbon Graphite (CHGI.OB)
Price (7/16/2009) - $0.66
Fiscal Year Ends in December

On July 1, 2009 The GeoTeam® coded China Carbon Graphite (OTCPK:CHGI)(chinacarboninc.com) as a GeoSpecial. At its current price the stock may offer an attractive risk reward opportunity. 

In 2007 the China Carbon saw its earnings per share grow 30.7% with a 47.2% increase in sales.  2008 saw a continuation of growth as sales and adjusted net income grew 7.7% and 11.1% respectively. 2008 growth would have been greater if it had not been for the Olympics which necessitated the closure of Xingyong's plant facilities as mandated by the Chinese government for the August 2008 Olympics. The closure caused the Company to shut down its production. The Company requires a 6 months production cycle and therefore was unable to resume production until March of 2009."  With operations back to normal the company is positioning itself to propel its growth rate to new heights. 

China Carbon is one of the China's top three producers of specialty graphite products. The Company's main products are graphite electrodes, fine grain graphite and high purity graphite. In general, the mineral is a valuable commodity in the Chemical, Mechanical, Nuclear and Electrical industries because of its ability to conduct heat and electricity and for its refractory nature (chemical and physical stability over a wide range of temperatures). These industries often need durable materials that can withstand conditions and processes over a long period of time, characteristics that lack in other industrial materials.

Graphite is considered to be one of the purest forms of carbon and highest grade of coal. Purity refers to the percent of carbon versus other non-carbon impurities found in the mineral. Graphite is one of two allotropes of carbon (the other being diamonds), the term allotrope meaning that it is a naturally occurring form of pure carbon. The chart below illustrates different grades of coal as they compare to carbon's allotropes. 

Mineral Name Volatiles % C Carbon % H Hydrogen % O Oxygen % S Sulfur %
Braunkohle (Lignite Coal) 45-65 60-75 6.0-5.8 34-17 0.5-3
Flammkohle (Flame coal) 40-45 75-82 6.0-5.8 >9.8 ~1
Gasflammkohle (Gas flame coal) 35-40 82-85 5.8-5.6 9.8-7.3 ~1
Gaskohle (Gas coal) 28-35 85-87.5 5.6-5.0 7.3-4.5 ~1
Fettkohle (Fat coal) 19-28 87.5-89.5 5.0-4.5 4.5-3.2 ~1
Esskohle (Forge coal) 14-19 89.5-90.5 4.5-4.0 3.2-2.8 ~1
Magerkohle (Non baking coal) 10-14 90.5-91.5 4.0-3.75 2.8-3.5 ~1
Anthrazit (Anthracite Coal) 7-12 >91.5 <3.75 <2.5 ~1
Graphite 7 >99 <1 <1 <1
Diamond 0 100 0 0 0
Click to enlarge

Element Constituents are by % Weight
Source: Wikipedia

There are three types of naturally occurring graphite; high crystalline graphite, amorphous graphite and flake graphite, all of which are named for observations that can be made about how they appear in their natural environments. However, graphite can also be artificially processed to obtain a synthetic form of the mineral.

Amorphous graphite has applications in metallurgy, pencil production, refractories, coating, lubricants and paint production.

Crystalline graphite can be used in batteries, lubricants, grinding wheels and powder metallurgy.

Flake graphite is used predominantly in refractory applications, mainly in secondary steel making; in addition to this it may also be used in lubricants, powder metallurgy, pencils and coatings. Most sources of natural graphite are also used in the fabrication of graphite foil.
 
Synthetic, or artificially prepared, graphites are used in aerospace applications, batteries, carbon brushes, graphite electrodes for furnaces and metallurgical processing, and moderator rods in nuclear power plants. China Carbon specializes in "using carbon rich raw materials to manufacturing graphite with a high degree of purity. The raw materials, purchased from domestic Chinese suppliers, include materials such as coal asphalt, asphalt coke, metallurgy coke, needle coke, metallurgy coke powder, quartzose sand, coal, petroleum coke and calcined coke. The extraction process typically requires a large amount of heat and several iterations of critical extraction steps before the desired purity is obtained.

Understanding China Carbon Graphite

China Carbon Graphite manufactures three types of synthetic graphite products. Each type of product can generally be broken down into different quality grades that determine its use.

Its products are generally used:

  • As a component in other products,
  • As an element of the machinery in a facility
  • To produce nuclear energy
  • In the manufacturing process of other products.

The company typically focuses on high end applications within its varying product lines.

1. Graphite electrodes line: Conducting material used for electric arc furnaces in the manufacture of steel and smelting alloy steel, brown alumina, yellow phosphorus, or other metals.

The electric arc furnace operates as a batch melting process producing batches of molten steel. The energy supplied during the smelting process can be either chemical or electrical. Electrical energy is supplied via the graphite electrodes and is usually the largest contributor in smelting operations.

2. Fine Grain graphite: Widely used in smelting for colored metals and rare-earth metal smelting as well as the manufacture of molds. (When liquid metal needs to poured into a container, that container must have a high tolerance for heat. Because graphite has a low sensitivity to heat, it is ideal for making molds in this scenario).

3. High purity graphite is used in metallurgy, mechanical industry, aviation, electronic, atomic energy, chemical industry, food industry and a variety of other fields. Common uses of this product line are the manufacture of molds, parts for machinery, automotive parts, lining in pipes to prevent chemical erosion, cubicles for silicon wafers and nuclear power plant applications. High purity graphite is generally lighter and less sensitive to heat than the aforementioned product lines.

Growth strategy. Going forward the company will follow a three pronged strategy:

1. Continue to serve the higher end markets in its Graphite electrodes line and Fine Grain graphite product lines.

2. Financing: The Company has applied for a $26 million loan financing from the PRC at below market rates. Use of proceeds: immediate acquisition, expansion of current plant and to purchase additional equipment for the manufacture of fine grain and high purity products.

  • The company has identified a potential acquisition target, that when purchased, would result in a 100% increase of both revenues and profits. If the transaction occurs it would double the size of the company in terms of revenue and net income.

3. Intensify its penetration into the high purity markets: A major impetus for growth will come from China Carbon's increased focus on its high purity graphite line.

There are numerous reasons to concentrate on the high purity graphite line:

1. Less competition

  • The majority of Chinese graphite manufacturing companies are not involved in the production of high purity graphite.
  • The expertise and high cost of machinery needed to manufacture high purity graphite is very demanding, creating a barrier to entry.
  • The company has a qualified and seasoned staff. This is important because "the reputation of the manufacturer and the quality of the product may be as important as price."

2. High purity graphite opens the door to a much broader array of markets. This should reduce the company's sensitivity to economic cycles when compared to its other product lines.

3. Margins in the high purity graphite line are significantly better as compared to its other product lines.

4. High purity graphite is becoming the preferred material of choice utilized in the production of nuclear plants. This trend presents an exciting opportunity on which China Carbon is poised to capitalize.

  • The projected significant investments in Chinese nuclear power industry provide opportunities for companies that are directly or indirectly involved in the nuclear power industry.
  • Energy demands and savings, as well as emission reduction requirements pose growing pressures for the fast development of the Chinese economy. Industry experts contend that nuclear power is the most competitive solution to change Chinese energy structures and meet the energy demands.
  •  By the end of 2008 a total of 11 nuclear power generating sets were in operation. The Chinese government is seeking to build 40 nuclear reactors by 2015.
  • In 2008 the annual nuclear power production was about 68 billion KWh, accounting for 2% of the total power production in China. The Chinese government plans that the installed capacity of nuclear power in China will eventually reach 5%, the electrical power production will reach 8% and the installed capacity of the nuclear power will exceed 70 million KW by 2020. If these estimates materialize, then the investments in Chinese nuclear power construction will total 720 billion Yuan (105 billion USD) in approximately 10 years.

The GeoTeam is speculating that the current stock price of China Carbon has been suffering as a result of the following reasons.

1. A capitalization issue arising from the reverse merger transaction in December 2007 called for the company to have to pay $4 million in fees. The initial payment of $800,000 was due by December 13, 2007 and the remaining $3,200,000 is due by September 13, 2009. Neither payment had been made.

  •  Problem solved- China Carbon has submitted capitalization reorganization plan to the PRC for approval. "We expect approval for the recapitalization in the next 60 days. These actions will effectively reduce the intercompany investment obligations owed to Yongle from $4,000,000 to $100,000 and eliminate possible fines or penalties by the PRC business bureau.

2. The 2008 Olympics resulted in short term facility shut downs.

  • Problem solved- "The sales decrease reflects the closure of Xingyong's plant facilities as mandated by the Chinese government for the Olympics in August 2008. The closure caused the Company to shut down its production. The Company requires a 6 months production cycle and therefore was unable to resume production until March of 2009." With the conclusion of the Olympics operations are back to normal.

3. Dilution due to financing needs for acquisitions and plant expansion.

  • Problem solved - "As one of the largest privately owned employers in Inner Mongolia, we have been recommended by the local government of Inner Mongolia to apply for a RMB 180,000,000 loan (approximately $26,000,000 US) through the Central government's economic stimulus plan. Once approved, it will expedite the process of doubling our production capacity to 30,000 metric tons annually and allow us to develop nuclear graphite for the more than 40 nuclear reactors the government is seeking to build by 2015."
  • Final approval for the loan and funding is expected in the fourth quarter of this year.

4. The six million outstanding warrants makes it difficult to compile an EPS estimate and accurately value the stock. The issue of potential dilution is still open and could put a short term cap on the stock unless:

  • The company considers steps to restructure the contract terms of the outstanding warrants, a step the GeoTeam® would highly recommend. To that end, the GeoTeam® has been able to confirm that China Carbon is preparing a repurchase agreement to retire 5 million warrants.
  • Completes an acquisition that can deliver EPS growth despite dilution.
  • Adds manufacturing capacity that can deliver EPS growth despite dilution.

5. No investor awareness initiatives.

  • Problem solved-

-China Carbon Graphite has retained the services of Ventana Capital Partners. (www.venturecapitalpartners.com)
-China Carbon Graphite has retained the services of Capital Group Communications. (www.capitalgc.com)
-Research report has been furnished by Crystal Equity Research which should help the company gain additional exposure. (www.crystalequityresearch.com)

The GeoTeam® will follow the CHGI story very closely. The stock may start to react positively when the loan and capital restructuring terms are actually approved. The company has provided guidance implying that it will experience sales and earnings growth in 2009.

As we look at the remainder of 2009, we expect that China Carbon will achieve a 15% to 25% increase in top line and bottom line in 2009. We are encouraged as the overall economic condition has been steadily improving in China. We are especially encouraged by the strong demand for our high quality fine grain graphite and high purity graphite.

It appears that this guidance does not take into account potential for acquisitions or manufacturing capacity increases, either of which could significantly add to the 2009 out look, a situation possibly needed in the short term for investors to get over dilutive issues.

Book Value Per Share using current outstanding shares: $2.61
Book Value Per Share including outstanding warrants:  $1.82

Enterprise Value Per Share using current outstanding shares: $1.15
Enterprise Value Per Share including outstanding warrants: $1.03

China Carbon's competitors include companies such as:

Graftech Intl Ltd (NYSE:GTI), price $10.00
Zoltek Companies, Inc. (NASDAQ:ZOLT), price $9.50

The GeoTeam® will publish complete valuation scenarios as events unfold.

Sources:

chinacarboninc.com
thefreelibarary.com
reportbuyer.com
crystalequityresearch.com

Disclosure: Long CHGI

Stocks: BAM, ZOLT